Limitations Of Selling Options
Option selling should be a straightforward endeavor. See an option you want to sell, sell it, wait until expiration, and collect the premium. You would think that it was as easy as pie, but for some reason it isnt. There are margin requirements along with inherent flaws in the structure of options that make the prospect of selling them difficult. Couple these problems with the claims that 70 percent to 80 percent of options are worthless when they expire and its no wonder that the average trader who ventures into selling options quickly finds himself in over his head.
Margin Requirements
While selling options should be a simple, if not easy, proposition, somehow selling options does not live up to the hype. In fact, while promoters tout the benefits of selling options and the easy money to be had, the truth is a lot less glamorous. Selling options is actually considered just as risky, if not more so, than buying options.
Technically the structure of an option does not favor option sellers. Once an option is sold it exposes the seller to unlimited risk. At the same time it only offers the option seller the meager profit that the premium has to offer. This unlimited exposure has led clearing firms in the futures market to require that option sellers have enough capital to protect themselves in case the market moves against them. Amounts may vary from clearing firm to clearing firm, but as a standard rule they will require the same margin amount as if you had initiated a futures contract.
For example, if you sold an option on a full-size S&P 500 contract, you would be able to collect $5,000 in premiums, but you would be required to put up $22,000 in margin for the privilege. So, even though it is assumed that selling options is superior to buying them, the simple fact that they can be so cost prohibitive leads traders to avoid them.
What about the collected premium?
The $5,000 in premium is treated like any futures or options position. Options are traded marked to market. If the volatility is on your side they will increase in value, if the volatility is against you they will decrease in value. The only time that the premium is actually considered yours by the clearing firms is when the option has expired and the trader is no longer exposed to unlimited risk. Until then the premium is not counted as part of your overall count value.
Poor Returns
The requirement that traders put up margin when they sell options also leads to what can be perceived as poor returns in comparison to the risk involved. If a trader has to expose $22,000 in margin in order to make $5,000, knowing full well that he could lose the entire $22,000 and possibly more if hes wrong, then it most likely is not the best possible bet to take. Add to this the fact that, depending on when the option expires, the traders capital can be tied up for months at a time, which can make option selling a discouraging endeavor for small traders.
If you are a small trader and you only have a $5,000 account your opportunities to sell options decrease even more. You would be lucky if you could comfortably sell an option worth $500, or 10 percent of your account value. This $500 income would not change the average retail traders life. For an account of this size there may only be four or five successful opportunities every year. If you are lucky and have no losses you could net $2,000 to $2,500 annually.
In addition, the possible annual returns look dismal, ranging from 40 percent to 50 percent, which is not what the average trader signs up for. This negative feeling toward such returns may not be warranted, though. A return of 40 percent to 50 percent a year exceeds the historical returns of the S&P 500, while at the same time beating out any bond, junk or otherwise. Even if the option selling strategy works out twice a year, producing $1,000 in premium based on this scenario, a 20 percent return would still exceed the stock markets past returns.
It goes without saying that CTAs that trade an option selling strategy benefit from a different financial scale than does the average retail trader. Small profits for a CTA accumulated over time turn out to be great gains. For a larger entity, 20 percent on $50 million yields a $10 million return. This kind of profits would put a CTA among some the top traders in the world.
The unglamorous nature of option selling leads retail traders to misunderstand the performance. There is no comparison between collecting option premiums and aggressively catching moves in the market. One is a passive action and the other is proactive. Therefore, selling options should not be put in the same category as buying options or obtaining a cash or spot position.
Percentage of Options that Expire Worthless
The perpetual myth is that 80 percent to 90 percent of options expire worthless. If this is the case, selling options should be like shooting fish in a barrel. Yet something is amiss. Not every trader, professional or retail, sells options. In fact, option selling is considered a specialized field that only a few select traders focus on. This simple fact gives a true glimpse into the nature of selling options, their difficulty, and the reality of the number of contracts that do actually expire worthless.
Margin Requirements
While selling options should be a simple, if not easy, proposition, somehow selling options does not live up to the hype. In fact, while promoters tout the benefits of selling options and the easy money to be had, the truth is a lot less glamorous. Selling options is actually considered just as risky, if not more so, than buying options.
Technically the structure of an option does not favor option sellers. Once an option is sold it exposes the seller to unlimited risk. At the same time it only offers the option seller the meager profit that the premium has to offer. This unlimited exposure has led clearing firms in the futures market to require that option sellers have enough capital to protect themselves in case the market moves against them. Amounts may vary from clearing firm to clearing firm, but as a standard rule they will require the same margin amount as if you had initiated a futures contract.
For example, if you sold an option on a full-size S&P 500 contract, you would be able to collect $5,000 in premiums, but you would be required to put up $22,000 in margin for the privilege. So, even though it is assumed that selling options is superior to buying them, the simple fact that they can be so cost prohibitive leads traders to avoid them.
What about the collected premium?
The $5,000 in premium is treated like any futures or options position. Options are traded marked to market. If the volatility is on your side they will increase in value, if the volatility is against you they will decrease in value. The only time that the premium is actually considered yours by the clearing firms is when the option has expired and the trader is no longer exposed to unlimited risk. Until then the premium is not counted as part of your overall count value.
Poor Returns
The requirement that traders put up margin when they sell options also leads to what can be perceived as poor returns in comparison to the risk involved. If a trader has to expose $22,000 in margin in order to make $5,000, knowing full well that he could lose the entire $22,000 and possibly more if hes wrong, then it most likely is not the best possible bet to take. Add to this the fact that, depending on when the option expires, the traders capital can be tied up for months at a time, which can make option selling a discouraging endeavor for small traders.
If you are a small trader and you only have a $5,000 account your opportunities to sell options decrease even more. You would be lucky if you could comfortably sell an option worth $500, or 10 percent of your account value. This $500 income would not change the average retail traders life. For an account of this size there may only be four or five successful opportunities every year. If you are lucky and have no losses you could net $2,000 to $2,500 annually.
In addition, the possible annual returns look dismal, ranging from 40 percent to 50 percent, which is not what the average trader signs up for. This negative feeling toward such returns may not be warranted, though. A return of 40 percent to 50 percent a year exceeds the historical returns of the S&P 500, while at the same time beating out any bond, junk or otherwise. Even if the option selling strategy works out twice a year, producing $1,000 in premium based on this scenario, a 20 percent return would still exceed the stock markets past returns.
It goes without saying that CTAs that trade an option selling strategy benefit from a different financial scale than does the average retail trader. Small profits for a CTA accumulated over time turn out to be great gains. For a larger entity, 20 percent on $50 million yields a $10 million return. This kind of profits would put a CTA among some the top traders in the world.
The unglamorous nature of option selling leads retail traders to misunderstand the performance. There is no comparison between collecting option premiums and aggressively catching moves in the market. One is a passive action and the other is proactive. Therefore, selling options should not be put in the same category as buying options or obtaining a cash or spot position.
Percentage of Options that Expire Worthless
The perpetual myth is that 80 percent to 90 percent of options expire worthless. If this is the case, selling options should be like shooting fish in a barrel. Yet something is amiss. Not every trader, professional or retail, sells options. In fact, option selling is considered a specialized field that only a few select traders focus on. This simple fact gives a true glimpse into the nature of selling options, their difficulty, and the reality of the number of contracts that do actually expire worthless.
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